Name ________KEY _________________
Finance 8310
Holland, Exit Exam
1. Determining the best way to raise cash for a business falls primarily into which of the following
topics?
a. capital budgeting
b. working capital management
c. net working capital management
* d. capital structure
e. financial distress
Answer: Raising cash for a business involves changes in the right side of the balance sheet, which
involves capital structure.
2. Which of the following is NOT a cash expense on the income statement?
a. income taxes paid
* b. depreciation
c. loan interest payments
d. wages paid
e. cost of goods sold
Answer: Depreciation is a non-cash deduction designed to account for the fact that fixed assets
wear out over time even though they were paid for at the time of installation.
3. Which of the following should be the goal of the financial manager of a corporation?
a.
b.
* c.
d.
e.
to minimize the variance of share prices in the long run
to maximize profit
to maximize current stock value
to maximize earnings
to maximize market share
Answer: A goal of financial management is to maximize the value of the firm, which also
translates into maximizing the current stock price.
1
Use the following information to answer questions 4 - 9.
Young, Inc.
Balance Sheets as of December 31, 1990 and 1991
($ in millions)
Assets
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Total Assets
1990
1991
$ 95 $ 102
335
400
369
438
799
940
1556 1841
$2355 $2781
Liabilities and Owners' Equity
Current Liabilities
1990
Accounts Payable
$ 200
Notes Payable
351
Total
551
Long-term debt
501
Common Stock
605
Retained Earnings
698
Total Liabilities
$2355
Young, Inc.
1991 Income Statement
($ in millions)
Net Sales
Less: Cost of Goods Sold298
Less: Depreciation
$795
182
Earnings before interest and taxes
Less: Interest paid
315
87
Taxable income
Less: Taxes
228
72
Net income
$156
Retained Earnings
Dividends Paid
138
18
4. What was Young's operating cash flow for 1991?
a.
b.
c.
* d.
e.
$159
$341
$351
$425
$477
Answer: OCF = EBIT + Depreciation – Taxes = 315 + 182- 72 = 425
5. What was the company's capital spending for 1991?
2
1991
$ 325
410
735
626
584
836
$2781
a.
* b.
c.
d.
e.
$385
$467
$637
$656
$822
Answer: Capital Spending = Ending NFA – Beginning NFA + Depreciation=1841-1556+182=467
6. What was the addition to net working capital for 1991?
* a. -$43
b. $2
c. $77
d. $161
e. $205
Answer: Ending NWC – Beginning NWC = (940-735) – (799-551) = 205-248 = -43
7. What was Young's cash flow from assets during 1991?
a. -$44
b. -$13
* c. $1
d. $79
e. $124
Answer: CF from Assets = OCF – Capital Spending - NWC = 425 - 467 - (-43) = 1
8. What was the company's cash flow to creditors in 1991?
a. $212
b. $87
c. $41
* d. -$38
e. -$212
Answer: CF to Creditors = Interest – Net New Debt = 87 – (626 – 501) = 87 – 125 = -38
9. What was the cash flow to stockholders?
a. -$3
3
b.
* c.
d.
e.
$18
$39
$61
$93
Answer: CF to Stockholders = Dividends – Net New Equity = 18 – (584 - 605) = 18 – (-21) = 39
10. Which of the following are sources of cash?
I. Increase in fixed assets
II. Accounts payable increase
III. Accounts receivable decrease
IV. Inventory increases
a.
* b.
c.
d.
e.
I only
II and III only
III and IV only
I, II, and III only
I, II, III, and IV
Answer: I. An increase in assets is a use, II. An increase in liabilities is a source, III. A decrease
in assets is a source, and IV. An increase in assets is a use. So II. and III. are sources of cash.
11. In words, what does a profit margin of .15 mean?
* a. For each $1 of sales generated, the firm has a net income of fifteen cents.
b. For each $1 of sales generated, the firm earns fifteen cents before operating expenses.
c. The percentage by which costs have been "marked-up" in order to arrive at sales.
d. For every $1 in net income, the firm must generate fifteen cents in sales.
e. The firm is operating above the break-even point.
Answer: The definition of profit margin is net income over sales, so “a” is correct.
12. Assume a firm's current ratio equals 3.5. Which of the following actions would decrease it?
* a.
b.
c.
d.
e.
discarding and writing off spoiled inventory
receiving payment on an account receivable
paying off a short-term loan with long-term debt
receiving payment of an overdue bill from a customer
selling inventory for cash
Answer: “a” is correct since a write-off of inventory will reduce the inventory account but not
affect other current assets or current liabilities, thus reducing the current ratio. “b” is incorrect
because receiving a payment will decrease accounts receivable but increase cash the same amount
leaving current assets at the same level. “c” is incorrect because paying off a short-term loan with
long-term debt will decrease current liabilities without affecting current assets, thus increasing the
4
current ratio. “d” is incorrect because receiving an overdue payment will again reduce accounts
receivable but increase cash by the same amount, thus leaving the current ratio the same. “e” is
incorrect because selling inventory for cash will reduce the inventory account but increase the cash
account (probably by a larger amount since the selling price will be above the carrying cost in
inventory) and thus not decrease the current ratio.
13. Between 1989 and 1993, the return on equity (ROE) of General Motors rose from 12.1% to
44.1%. During this same time, the profit margin actually declined as did the return on assets.
Which of the following caused this apparent contradiction?
a. Net income increased even though sales did not change much.
* b. The balance sheet was restated to reflect pension liabilities, and this caused equity to
decrease drastically, driving the equity multiplier way up.
c. The asset turnover increased dramatically, which indicates that assets were being used much
more efficiently.
d. A large amount of inventory was written off, which reduced profits, but increased cash flow.
e. Foreign competition caused GMs market share to decrease, which caused the stock price to
fall and ROE to increase.
Answer: “a” is incorrect because the problem states the profit margin decreased, so income could
not have increased and cause the profit margin to decrease unless the sales increased dramatically,
but the answer says that sales did not change much. “b” is correct because a reduction in the value
for equity would make the equity multiplier go up, and from the DuPont equation this could
increase ROE even though the profit margin and the asset turnover declined somewhat. “c” is
incorrect because the asset turnover could not have increase dramatically. “d” is incorrect because
writing off inventory reduces the reported net income, but this would reduce ROE (Net Income /
Equity). “e” is incorrect because a fall in the stock price does not change reported ROE, which is
calculated from book values.
14. A firm's ________ indicates the amount by which sales and assets can grow without the firm
needing to sell additional equity or change its debt to equity ratio or payout ratio.
a. dividend payout ratio
* c. sustainable growth rate
e. projected sales growth rate
b.
d.
retention ratio
growth rate with no external financing
Answer: This is the definition of the sustainable growth rate.
5
Use the following information to answer questions 15 - 20.
Stansfield Corporation
Income Statement
($ in millions)
Sales
Costs
Taxable Income
Taxes
Net Income
$250
200
50
17
33
Ret. Earnings
Dividends
27
6
Stansfield Corporation
Balance Sheet
($ in millions)
Assets
Current Assets
Cash
Accounts Receivable
Inventory
Total
120
Fixed Assets
Property, Plant,
and Equipment
Total Assets
$ 5
40
75
180
300
Liabilities and Owners' Equity
Current Liabilities
Accounts Payable
Notes Payable
Total
Long-term debt
Owners Equity
Common Stock and APIC
Retained Earnings
Total
Total Liabilities
$ 40
10
50
100
75
75
150
300
15. How much external financing is needed for a 20 percent increase in sales if the Corporation is
currently operating at full capacity?
a. $0 million
b. $13.2 million
* c. $19.6 million
d. $28 million
e. $37 million
Answer: This can be calculated by using the percent of sales Excel spreadsheet template.
6
16. Assume Stansfield Corporation is utilizing its fixed assets at 80 percent capacity. What would be
the external financing need if sales increase by 20 percent?
a. -$26.4 million
* b. -$16.4 million
c. $13.2 million
d. $19.6 million
e. $28.0 million
Answer: This can be calculated from the spreadsheet template, changing the % capacity to 80%.
17. What is the internal growth rate for Stansfield Corporation?
a.
b.
c.
* d.
e.
3.68 %
6.53%
9.89%
11.59%
15.24%
Answer: This is calculated on the spreadsheet template using the formula
IGR = b*ROA/(1-b*ROA).
18. What is Stansfield Corporation's sustainable growth rate?
a.
b.
c.
d.
* e.
3.68 %
6.53 %
10.83 %
11.59 %
21.95 %
Answer: This is calculated on the spreadsheet template using the formula
SGR = b*ROE/(1-b*ROE).
19.
What is the actual internal growth rate assuming 80% capacity?
a. 6.53%
b. 9.89%
c. 11.59%
* d. 31.98%
e. 46.72%
Answer: The actual internal growth rate must be calculated with trial and error using the
spreadsheet template. The easiest way to solve this problem is to use the answers in the multiple
choice question as the trial choices.
7
20.
What is the actual sustainable growth rate assuming 80% capacity?
a. 21.95%
b. 31.98%
* c. 46.72%
d. 51.17%
e. 63.55%
Answer: The actual sustainable growth rate must be calculated with trial and error using the
spreadsheet template by changing the growth rate and then adding the resulting EFN to one of the
debt accounts. The correct answer is reached when the debt to equity ratio for the pro forma
balance sheet equals the debt to equity ratio of the actual numbers. The easiest way to solve this
problem is to use the multiple choice answers as the trial guesses.
21. Suppose you notice in the Higgins textbook the formula for the growth rate of the firm,
which after some effort to re-arrange the notation looks like g=b*ROE. However, you also note
in the Ross et. al. textbook that the sustainable growth rate formula is different,
SGR=b*ROE/(1-b*ROE). Since these two formulas are clearly different, which one
is correct? (Make sure you pick the most correct answer here, not one that simply has some
correctness).
a. Higgins is correct, and Ross, et. al. is incorrect.
b. Ross, et. al. is correct, and Higgins is incorrect.
* c. They are both correct, but the Higgins formula looks different because the ROE uses
beginning of period equity rather than the standard end of period equity as in the Ross, et.al.
equation. Given this modified definition, they both yield the same number.
d. Actually, neither equation is correct even given the simplified assumptions that are made.
The sustainable growth rate is better determined using the dividend growth model.
Answer: “c” gives the correct explanation for the difference in the equations. Actually, Higgins
points this difference out clearly in a footnote to the equation.
22.
A student who was testing my Excel template on the percent of sales pro forma forecasting
method noted that the Internal Growth Rate (IGR) formula (IGR=b*ROA/(1-b*ROA) ) did not
give the correct answer of EFN=0 when the capacity utilization in the actual year was less than
100%. Which of the following is most correct?
a. The equation is correct, so the spreadsheet must have an error in it.
b. The spreadsheet can certainly be correct with an EFN=0 at the IGR , so the formula in the
cell may be in error.
* c. Neither is really in error. The formula naively assumes all items in the income statement and
the left side of the balance sheet (when NWC is on the left side) grow at the same rate as
sales. When capacity is less than 100%, the fixed assets do not grow at the same rate as
sales. Thus, the pro forma approach would yield a higher actual Internal Growth Rate than
the formula. So the EFN should not be zero at the IGR when capacity is less than 100%.
d. Answer c is correct except that the pro forma approach should give a lower IGR.
Answer: The formula does indeed assume that everything other than debt and equity grows at the
same rate as sales. At any level of capacity utilization other than 100%, this assumption is
8
violated.
23.
What is the operating leverage of a company if all costs are variable?
a. Zero
* b. 1
c. Infinite or undefined
d. None of the above
Answer: One formula for calculating the operating leverage is OL = 1 + Fixed Cost/OCF.
So when fixed costs are zero, the operating leverage is 1.
24.
Which of the following is true concerning the IGR formula.
a. The IGR formula assumes a degree of operating leverage of zero.
* b. The IGR formula assumes a degree of operating leverage of 1.
c. The IGR formula assumes a degree of financial leverage of zero.
d. The IGR formula assumes a degree of financial leverage of 1.
e. The IGR formula makes no assumption about operating leverage.
Answer: Since the formula assumes all items increase at the rate of sales except debt and equity,
this by definition means that there are no fixed costs. Thus the operating leverage is assumed to be
equal to 1.
25.
What would your monthly payment be on a 30-year, $150,000 mortgage at nine percent
compounded monthly?
a. $416.67
b. $934.14
c. $1,000.39
* d. $1,206.93
e. $1,541.29
Answer: Use the spreadsheet template TVMoney.xls to solve the time value of money problems.
N=360, Interest rate=.09/12=.0075, Present Value = 150,000. Therefore the Payment = $1,206.93.
26. How much money will you have in eight years if you deposit $250 in a savings account today that
earns 6.5 percent compounded annually?
a. $251.30
b. $316.89
c. $412.28
* d. $413.75
e. $417.04
Answer: N=8, Interest rate=6.5%, Present Value=250. Therefore, the Future Value=$413.75.
27. The mortgage on your house has a payment of $663.81 per month. It is a 30 year mortgage at 9.0
percent compounded monthly. How much did you borrow?
9
a. $75,000
c. $80,000
e. $85,000
b.
* d.
$77,500
$82,500
Answer: N=360, Interest rate=.09/12=.0075, the Payment=663.81. Therefore, the PV=82,500.
28. What is the effective annual rate of eight percent compounded semiannually?
a. 8.00 percent
c. 8.46 percent
e. 16.64 percent
* b.
d.
8.16 percent
8.73 percent
Answer: APY = 1.042 –1 = 1.0816 – 1 = .0816 or 8.16%
29. You are saving money to buy a house in ten years. You will need $25,000 to make the down
payment at that time. How much must you deposit in a savings account each month for the next
ten years in order to save up $25,000 if the savings account pays interest at 12 percent per year
compounded monthly?
a. $93.42
* b. $108.68
c. $152.97
d. $208.33
e. $271.21
Answer: N=120, Interest rate = .12/12= .01, Future Value = 25,000. Therefore, Payment=$108.68
30. Darwin Davis just established an IRA (Individual Retirement Account.) Darwin decides to put $50
per month into this account for the next 40 years. Since he plans to invest in a small stock mutual
fund, he estimates he will earn 18 percent per year compounded monthly. How much money
would be in this account after 40 years?
a. $24,000
b. $372,421
c. $913,652
* d. $4,228,992
e. $17,576,113
Answer: N=480, Payment=50, Interest rate=.18/12 = .015. Therefore, Future Value = $4,278,992
31.
How much would you have to invest today at 12 percent compounded semiannually to have
$25,000 to buy a trailer house in 4 years?
a. $13,492.13
b. $13,957.87
10
c. $14,789.36
e. $16,665.73
* d.
$15,685.31
Answer: N=8, Interest rate=.12/12 = .01, Future Value = 25,000. Therefore, Present Value =
$15,685.31
32. You need to borrow $18,000 to buy a truck. The current loan rate is 11.9 percent compounded
monthly, and you want to pay off the loan in equal monthly payments over 5 years. What is your
monthly payment?
a. $363.39
b. $394.04
* c. $399.49
d. $407.86
e. $621.43
Answer: N = 60, Interest rate = .119/12 = .00991667, Present Value = 18,000. Therefore, the
Payment=$399.49
33.
A local automobile dealer is offering 1.9% financing on a 3-year car loan or $2,000 for the
purchase of an $18,000 car. Suppose you also have available financing at 9% for a 3-year car loan
through your bank. Given these two options, you would like to know which is the better deal.
Which option would be the lowest monthly payment over 3 years for purchasing the car? (Assume
you finance the entire purchase price at 1.9% or $16,000 at 9%).
a. $500.00 per month.
b. $503.56 per month.
* c. $508.80 per month.
d. $514.78 per month.
e. $518.56 per month.
Answer: Both monthly payments must be calculated. The $2,000 rebate is the best option.
1.9% APR: N=36, Interest rate=.019/12, Present Value=18,000. Thus, Payment=$514.78
Rebate: N=36, Interest rate=.09/12, Present Value=16,000. Therefore, Payment=$508.80
In 1889, Vincent Van Goghs painting, Sunflowers, sold for $125. One hundred years later, it
sold for $36 million. Had the painting been purchased by your great-grandfather and passed on to
you, how much would your average compounded rate of return have been?
a. 9.1%
b. 10.1%
c. 11.9%
d. 12.0%
* e. 13.4%
34.
35.
Answer: N=100, Present Value=125, Future Value=36,000,000. Thus, Int. rate=13.4%
All else being equal, if interest rates rise,
I. bond prices will fall,
II. coupon payments will rise,
11
III. the prices on long-term bonds will fall more (on a percentage basis) than prices on shortterm bonds, and
IV. the number of years to maturity increases.
* a.
c.
e.
I and III only
II and IV only
I, II, III, and IV
b.
d.
I and IV only
I, III, and IV only
Answer: I is true because interest rates and bond prices move in opposite directions. II is false
because the coupon interest payament is constant throughout the life of a bond. III is true because
Long-Term bonds are exposed a longer time to changes in interest rates (i.e. more sensitive). IV is
false because the maturity date is independent of changes in interest rates.
36.
A bond sold five years ago for $950. The bond is worth $900 in today's market. Assuming no
changes in risk, which of the following is true?
a. The face value of the bond must be $900.
b. The bond must be within one year of maturity.
c. Interest rates must be lower now than they were five years ago.
* d. Interest rates must be higher now than they were five years ago.
e. The coupon payment of the bond must have increased.
Answer: Five years ago, the bond sold at a discount. Today, it sells for even more of a discount.
Normally, I would expect the price of the bond to increase as its value marches toward $1,000 at
maturity. The fact that the price went down means that interest rates must have increased.
37.
Terminator Bug Company bonds have a 14% coupon rate. Interest is paid semiannually. The
bonds have a par value of $1,000 and will mature 10 years from now. Compute the value of
Terminator Bonds if the investors required rate of return is 12%.
a. $894.06
b. $1,000
* c. $1,114.70
d. $1,149.39
e. $1,215.62
Answer: N=20, Payment=70, Future Value=1000, Interest Rate=6%. Thus, PV=1114.70
38.
The dividend on Soviet Motors common stock will be $6.00 in one year, $6.50 in two years, and
$7.00 in three years. You know you can sell the stock for $75 in three years, and you require a 10
percent return on your investment. How much would you be willing to pay for a share of this
stock?
a. $61.50
b. $64.65
12
c.
e.
$68.90
$88.50
*
d.
$72.43
Answer: P0 = 6.00/1.10 + 6.50/1.102 + (7+75)/1.103 = 72.43
39. The current price of ABC Corporation is $50.00. Dividends are expected to grow at 4 percent
indefinitely, and the most recent dividend was $2.00. What is the required rate of return on ABC's
stock?
* a. 8.2 percent
b. 9.1 percent
c. 10.2 percent
d. 11.6 percent
e. 13.2 percent
Answer: RE = (2.00*1.04)/50.00 + .04 = .0816 or 8.16%
40. What would you pay for a share of ABC Corporation stock if it is going to pay a $5 dividend and
be worth $110 in one year? You require a 15 percent return on your equity investments, and ABC
Corporation's bonds currently yield 9 percent.
a. $95
*
b. $100
c. $110
d. $115
e. $120
Answer: P0 = (110+5)/1.15 = $100
41. What would you pay for a stock that just paid a $5 dividend if the expected dividend growth rate is
4 percent and you require a 16 percent return on your investment?
a. $33.33
*
b. $43.33
c. $51.43
d. $77.14
e. $84.30
Answer: P0 = (5.00*1.04)/(.16-.04) = $43.33
42. Etling, Inc., dividend is expected to grow at 10 percent for the next 2 years and then at 5 percent
forever. The current dividend is $2, and the required return is 22 percent. What is a fair price for
this stock?
* a. $13.47
b. $14.00
c. $14.15
d. $15.10
e. $19.05
13
Answer: P0=(2.00*1.1)/1.22+(2.00*1.12)/1.222+((2.00*1.12*1.05)/(.22-.05))/1.222 = 13.47
You could also use the TVMoney spreadsheet with the stock valuation worksheet.
43. Which of the following consider the time value of money in their computation?
I.
II.
III.
IV.
Payback
Net Present Value
Profitability index
Internal rate of return
a. III only
c. II and IV only
e. I, II, III, and IV
*
b.
d.
II only
II, III, and IV only
Answer: Payback is the only one that does not use the time value of money concept.
44.
If you wish to quantify, in dollar terms, how stockholder wealth will be affected by undertaking a
project under consideration, you should use:
a. discounted payback analysis.
b. the average accounting return.
c. internal rate of return.
*
d. net present value.
e. the profitability index.
Answer: This is the concept of net present value.
45. What is the decision rule for IRR?
a. accept a project when IRR > 0
b. accept a project when IRR > r where r is the going market rate on the firm's bonds
c. accept a project when IRR > 100 percent, indicating that the project has more than recaptured
its initial cost
d. accept a project if the IRR exceeds the risk free rate of return
* e. accept a project if the IRR exceeds the firm's required rate of return
Answer: When the IRR is larger than the required rate of return, the NPV will be positive.
46. What is the decision rule for NPV?
* a. accept a project when NPV is positive
b. accept a project when NPV exceeds average accounting net income
c. accept a project when NPV > cost, indicating that the project has more than recaptured its
initial cost in terms of net income
d. accept a project when NPV exceeds the firm's target NPV
14
e. accept a project when NPV is negative only if the IRR is positive
Answer: When the NPV is positive, the project earns more than the required rate of return.
47.
What is the decision rule for Profitability Index (PI)?
a. accept a project when the PI is positive.
* b. accept a project when the PI is greater than 1.
c. accept a project when the PI is greater than the required rate of return.
d. accept a project when the PI is greater than the Internal Rate of Return (IRR).
e. accept a project when the PI is greater than the risk free rate.
Answer: When the PI is greater than 1, you can earn more than $1.00 for every dollar you invest in
the initial outlay.
48.
Consider a project with an initial investment and positive future cash flows. As the discount rate is
decreased, the:
* a. IRR remains constant while NPV increases.
b. IRR decreases while NPV remains constant.
c. IRR remains constant while NPV decreases.
d. IRR increases while NPV remains constant.
e. IRR increases while NPV decreases.
Answer: When the discount rate is decreased, the NPV will increase. The IRR is independent of
the required rate of return.
49.
Suppose you are considering a project that costs $10 and has expected cash flows of $4, $4, and $5
over the next three years. If the appropriate discount rate for the project's cash flows is 14 percent,
what is the net present value of this project?
* a. -$0.04
b. $0.21
c. $0.71
d. $9.79
e. $10.71
Answer: Use TVMoney spreadsheet and the Capital Budgeting worksheet.
Cash flows = {-10,4,4,5}, Required Return=14%. Then the NPV = $.04
50.
A project has an initial investment of $10,000. The expected future cash flows are $3,000 per year
for the next 4 years. If the required rate of return is 15 percent, what is the NPV?
a. -2,084
*
b. -1,435
c. -132
d. 0
e. +2,076
15
Answer: Use TVMoney spreadsheet and the Capital Budgeting worksheet.
Cash flows = {-10,3,3,3,3}, Required Return=15%. Then the NPV = -$1.435
51. You are considering an investment with the following cash flows. Your required return is 10
percent, and all else being equal, you prefer at least a payback of 2 years. If your primary objective
is to maximize your wealth, should you take this investment? (Hint: use the best approach to
evaluate this project.)
Year
Cash Flow
0
-100,000
1
60,000
2
60,000
3
10,000
4
10,000
5
-50,000
a.
b.
c.
* d.
e.
Yes, the payback is 1.67 years.
Yes, the discounted payback is 1.92 years.
Yes, because both the payback and discounted payback are less than 2 years.
No, because the NPV is $-12,571.
You cannot decide because the decision rules conflict.
Answer: Since you want to know how much your wealth changes, NPV is the correct statistic to
calculate. Use the TVMoney spreadsheet and the Capital Budgeting worksheet.
Cash flows = {-100,60,60,10,10,-50}, Required return = 10%. Then NPV = -$12,571
The payback is okay, but that doesn’t matter because your primary objective is to increase your
wealth.
52.
Suppose you are the operator for a large football stadium with thousands of stadium lights. A light
bulb salesman has given you a pitch that his better quality bulbs, though somewhat more
expensive, last for seven years as compared to standard bulbs that last only three years. Both types
of bulbs give the same lumen output (i.e., brightness). Which of the following is the best and
easiest way to determine whether it is better to buy the high quality or standard bulbs?
a. Multiply the price of the high quality bulbs times 3/7 and if that is lower than the price of
standard bulbs, choose the high quality bulbs.
16
b.
Find the NPV of a 3 year project for standard bulbs and the NPV of a 7 year project for
high quality bulbs using only costs. Choose the one with the lowest cost (the smallest
negative number).
c. Same as b except choose the largest negative number.
d. Same as b except chain the projects for 21 years so they will be of an equivalent project
life.
* e. Find the equivalent annual annuity for each project and choose the one with the lowest cost
per year (the smallest negative number).
Answer: The correct approach is to find the equivalent annual annuity, because the projects are of
different length. Answer “a” does not count the time value of money. Answer “b” incorrectly
compares projects of different length (i.e., the 7-year project is productive for four more years,
even more than two consecutive 3-year projects). Since only costs are included, the smallest
negative number is correct. If instead you entered a negative number as a cost, this turns the
projects into positive cash flows and the largest positive number should be chosen. Answer “d”
would also work, but the process is cumbersome. Answer “e” is by far the easiest way to solve this
problem.
53.
The government has been trying to decide whether to purchase any of the stealth bombers. One of
the arguments in favor of purchasing the bombers is that since so much money has been spent on
its development, it would be a waste of money not to buy any. What is the major problem with this
argument?
a. It doesn't consider the opportunity cost of the money that has been spent.
* b. It includes sunk costs in the decision.
c. It includes possible erosion of the purchase of other bombers.
d. It includes changes in net working capital.
e. It includes financing costs in the decision.
Answer: This is the classic problem of not counting expenditures that have already been made.
Obviously, this will not change what the future holds, which is the only thing that matters.
54.
Your company purchased a piece of land seven years ago for $150,000 and subsequently added
$75,000 in improvements. The current book value of the property is $225,000. There are three
options for future use of the land: (1) the land can be sold today for $375,000, (2) the land can be
leased to another party on a long-term basis, or (3) your company can destroy the past
improvements and build a factory on the land. In consideration of the factory project, at what
amount (if any) should the land be valued?
a. the present book value of $225,000
b. the sales price of $375,000 plus $75,000 in improvements
17
c.
* d.
e.
the sales price of $375,000 less the book value of the improvements since they will be
destroyed anyway
whichever amount represents the greatest opportunity cost; that is, the best alternative use you
must forego in order to build the factory ($375,000 or the value of the long-term lease,
whichever is greater)
The property should be valued at zero since it is a sunk cost.
Answer: You have to count the incremental cost of foregoing the opportunity to earn $375,000 by
selling the property or perhaps even more from a long-term lease. Answer “a” is incorrect because
the book value has nothing to do with incremental cash flow (it merely reflects historically how
much was paid less accumulated depreciation). Answer “b” is not correct because the $75,000
improvements are a sunk cost. Answer “c” is incorrect again because the book value of
improvements do not affect incremental cash flows. Answer “e” is incorrect because the property
has the potential of future cash flows, which will be eliminated if the project proceeds.
18
Use the following table to answer the next three questions.
Modified ACRS Depreciation Allowances
Property Class
Year
1
2
3
4
5
6
7
8
55.
3-Year
5-Year
33.33%
44.44%
14.82%
7.41%
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
7-Year
14.29%
24.49%
17.49%
12.49%
8.93%
8.93%
8.93%
4.45%
Your company just purchased a new computer system for $160,000. Computers have a 5-year
ACRS classification. At the end of two years, what will be the book value of this computer?
a. 0
b. 32,000
c. 51,200
*
d. 76,800
e. 160,000
Answer: Book Value = 160,000 - .2000*160,000 - .3200*160,000 = 76,800
56. If the computer is sold for $100,000 in year 2, what would be the salvage value cash flow?
Assume a corporate tax rate of 40 percent and that you get a full year of depreciation in year 2.
a. $13,900
b. $49,920
c. $60,000
*
d. $90,720
e. $100,000
Answer: A/T Salvage CF = 100,000 – (.40)(100,000-76800) = 90,720
57. Your company just bought some new equipment for its manufacturing plant. The equipment cost
$1,000,000. Industrial equipment has an ACRS classification of 7 years. If the equipment will be
sold in 3 years for $224,900, what is the after-tax cash flow from the sale? The corporate tax rate
is 34 percent.
a. $27,784
b. $66,000
c. $72,216
d. $172,216
* e. $297,116
Answer: Book Value=1,000,000-.1429(1,000,000)-.2449(1,000,000)-.1749(1,000,000) = 437,300
A/T Salvage CF = 224,900 - .34(224,900 – 437,300) = 297,1166
19
The following data applies to the next 5 questions.
The Johnson Jojoba Ranch is considering the acquisition of a new crushing machine for its refining
operation. The machine would save $45,000 per year, but it would require a maintenance expense of
$10,000 per year (for a net savings of $35,000 a year). The machine would cost $100,000 and has an
economic life of five years. After this time, it is expected that the machine could be sold for $20,000.
Johnson's cost of borrowed funds is 13 percent, and the marginal cost of capital is 17 percent. The
company uses the straight-line method to calculate depreciation, depreciating toward a zero book value.
The marginal corporate tax rate is 40 percent.
58. What is the operating cash flow per year for this project?
a.
c.
e.
$24,000
$35,000
$55,000
*
b.
d.
$29,000
$41,000
Answer: OCF = (1-t)(Savings) + (t) Depreciation = (1-.40)(35,000) + (.4)20,000 = 29,000
59. What is the after-tax salvage cash flow?
a.
c.
* e.
$23,400
$18,000
$12,000
b.
d.
$20,000
$17,094
Answer: Since Book Value = 0, A/T Salvage CF = (1-t)(Salvage) = .6(20,000) = 12,000
60. What is the Net Present Value (NPV) of this project?
a.
* c.
e.
-9,642
-1,745
+14,560
b.
d.
-5,798
+200
Answer: Enter the data on the Cash Flows worksheet. NPV = -1,745
61.
What is the Internal Rate of Return (IRR) of this project?
a. 0.98%
b. 13.15%
* c. 16.27%
d. 21.79%
e. 23.41%
Answer: Enter the data on the Cash Flow worksheet. IRR = 16.27%
62.
What is the Profitability Index (PI) of this project?
20
a.
* c.
e.
-.88
.98
1.20
b.
d.
-.98
1.17
Answer: Enter the data on the Cash Flow worksheet. PI = .98
63.
What is the Payback for this project?
a. 1.75 years
* c. 3.45 years
e. 4.95 years
b.
d.
2.36 years
4.16 years
Answer: Enter the data on the Cash Flow worksheet. Payback = 3.45 Years
Use the following information to answer the next five questions.
Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost
$160,000. Bill expects the after tax cash inflows to be $40,000 annually for 7 years, after which he plans
to scrap the equipment and retire to the beaches of Jamaica.
64.
What is the projects payback period?
a. 1.5 years
b. 2.0 years
c. 3.3 years
* d. 4.0 years
e. 4.3 years
Answer: Enter the data on the Capital Budgeting worksheet. Payback = 4.0 Years
65.
Assume the required return is 10%. What is the projects discounted payback period?
a. 3.2 years
b. 4.8 years
* c. 5.4 years
d. 6.5years
e. 7.1 years
Answer: Enter the data on the Capital Budgeting worksheet. Discounted Payback = 5.37 Yr.
21
66.
Assume the required return is 10%. What is the projects NPV?
a. $14,111
b. $27,322
c. $32,556
* d. $34,737
e. $45,001
Answer: Enter the data on the Capital Budgeting worksheet. NPV = 34,737
67.
Assume the required return is 17%. What is the projects IRR?
a. 12.2%
b. 14.3%
* c. 16.3%
d. 17%
e. 19.3%
Answer: Enter the data on the Capital Budgeting worksheet. IRR = 16.33%
Note that the required rate of return does not change the IRR.
68.
Assume the required return is 15%. What is the projects PI?
a. .74
b. .88
c. 1.0
* d. 1.04
e. 1.16
Answer: Enter the data on the Capital Budgeting worksheet. PI = 1.04
69. After ten years as an automobile factory worker, Joe decides he is just tired of working for others.
He decides to enter the highly competitive mountain bike manufacturing business. He finds a
large, positive NPV. Which of the following is probably true about his analysis?
22
a.
* b.
c.
The discount rate he used must be too high.
Unless he has added something of value to the manufacturing process, he probably made a
mistake in estimating his cash flows.
He has likely been overly pessimistic about the future and has underestimated future cash
flows.
His estimates of initial outlays must be on the high side.
His analysis is probably correct since he will be able to sell his bikes because they are identical
to those already in the market.
d.
e.
Answer: It is very difficult to find positive NPV projects. It is unlikely that Joe can easily find a
high NPV project in a highly competitive manufacturing business unless he has incorporated some
feature that is not easily duplicated by the market or has found some way to manufacture the bikes
at a lower cost than the competition. Since he seems to have done neither of these, it is likely that
he has made a mistake in estimating his cash flows too high.
Use the following information about two projects to answer the next 5 problems.
Year
Cash Flows A
Cash Flows B
0
1
2
3
4
5
-$100,000
31,250
31,250
31,250
31,250
31,250
-$100,000
0
0
0
0
200,000
The required rate of return for both projects is 12%.
70.
What is the Payback period for Project A?
a. 2.5 years
* b. 3.2 years
d. 4.3 years
e. 5 years
c. 3.8 years
Answer: Payback = 3 + (100,000-31250-31250-31250)/31250 = 3.2 years
71.
What is the Net Present Value of Project A?
a. -$8,237
b. +$8,237
d. +$13,485
e. +$16,835
* c. +$12,649
Answer: NPV = -100,000+31250/1.12+31250/1.122+31250/1.123+31250/1.124+31250/1.125
NPV = 12,649
72.
What is the IRR of Project A?
a. -2.3%
b. 8.6%
c. 14.9%
* d. 17.0%
e. 21.5%
23
Answer: Enter cash flows on the Capital Budgeting worksheet. IRR = 16.99% or 17%
73.
What is the Profitability Index of Project A?
a. -1.126
b. -1.082
d. 1.082
* e. 1.126
c. 0.893
Answer: Enter cash flows on the Capital Budgeting worksheet. PI = 1.13
74.
Given that these two projects are mutually exclusive, what should be your recommendation?
a. Pursue Project A
c. Dont pursue either project
* b. Pursue Project B
d. Pursue both projects
Answer: Purse Project B because it has the highest NPV.
75.
What is the IRR of an investment that costs $76,937 and pays $32,000 a year for 4 years?
a. 16%
c. 20%
* e. 24%
b. 18%
d. 22%
Answer: Enter the cash flows into the Capital Budgeting worksheet. IRR = 24%
76.
Which of the following is correct about project evaluation?
a. Financing costs must be included in the statement of cash flows because they are not
accounted for elsewhere.
* b. The stand-alone principle calls for evaluation of a project based on the projects
incremental cash flows.
c. Changes in NWC are not considered incremental cash flows.
d. When fixed assets are sold at the end of a project, there are usually no tax consequences of
the sale.
e. Whether straight-line depreciation or MACRS depreciation is used will have no impact on
the NPV of a project.
77.
*
Answer: Answer “a” is incorrect because financing costs are accounted for in the WACC.
Answer “b” is correct because we are looking only for incremental cash flows as a stand-alone
project. Answer “c” is incorrect because NWC changes are indeed incremental cash flows.
Answer “d” is incorrect because there usually are tax consequences when an asset is sold at the
end of a project. Answer “e” is incorrect because the cash flows are indeed different with
different methods of counting depreciation.
Over the past 65 years, which of the following investments has provided the greatest return?
a. small company stocks
b. common stocks
c. Treasury bills
d. Treasury bonds
e. corporate bonds
24
Answer: Small company stocks have the highest expected returns and the highest risk.
78.
Using CAPM, what is the expected return on asset A if the expected return on the market is 17
percent and the risk-free rate is 7.7 percent? Asset A has a beta of .9.
a. 9 percent
b. 10 percent
c. 14 percent
* d. 16 percent
e. 20 percent
Answer: E(R)=Rf+Beta (Expected Market Risk Premium)=7.7%+.9 (17% - 7.7%)=16%
79.
*
A firm unexpectedly increases its dividend payout and its stock price rises. The asymmetric
information effect at least partially explains the rise in stock price since:
a. investors react favorably to the increased dividend because this indicates a better financial
condition in the future.
b. investors will always react favorably to changes in dividends.
c. an unexpected increase in dividends means management is signalling that the firm has no
positive NPV projects in which to invest.
d. this unexpected increase will likely be viewed as an attempt by management to manipulate
the stock price.
e. unexpected changes in dividends will not affect stock prices if the firm has a written policy.
Answer: Answer “a” reflects the signaling effect from a change in dividends under asymmetric
information. Answer “b” is inconsistent with the clientele effect. Answer “c” is opposite to the
asymmetric information effect. If the management increases dividends, this could place the firm
into financial distress if the future turns out to be bad. Therefore, the asymmetric information
effect would suggest an increase in dividends only when the future looks bright. Answer “d”
does not reflect the way the market responds to unexpected increases in dividends. Again, if the
management is not telling the truth, there jobs could be in jeopardy because of possible financial
distress from too high a dividend payout. Answer “e” is incorrect because the market generally
does not respond to statements of policy – the market generally responds to real changes in cash
flow or perceived real changes in future cash flows.
25
The next three questions refer to the following:
You are considering a project that requires an initial investment of $10,000. It is depreciable over
four years using straight-line depreciation. The discount rate is ten percent. Your tax bracket is 34
percent.
Base Case
Unit Sales
3,000
Price per Unit
$15.00
Variable Cost per Unit
$9.00
Fixed Costs
$9,000
80. Assume a salvage value of zero. What is the base case accounting break-even?
a. 1,083
* c. 1,917
e. 2,237
b.
d.
1,500
2,026
Answer: Accounting B/E = (Fixed+Depreciation)/(Price-Variable Cost) = (9,000+2500)/(15-9)
= 11,500/6 = 1917
81. What is the base case cash break-even? Ignore taxes and assume a salvage value of zero.
a. 1,083
c. 1,917
e. 2,237
* b.
d.
1,500
2,026
Answer: Cash B/E = (Fixed Cost)/(Price-Variable Cost) = (9000)/(15-9) = 1500
82. What is the base case financial break-even? Ignore taxes and assume a salvage value of zero?
a. 1,083
c. 1,917
e. 2,237
b.
* d.
1,500
2,026
Answer: Financial B/E = (Fixed Cost + OCF*)/(Price-Variable Cost)
First calculate OCF* = 10,000/((1-1/1.104)/.10) = 3154.71
Financial B/E = (9000+3154.71)/(15-9) = 2025.78 or 2026
83. At the financial break-even point, the IRR of a project is equal to
a. 0 percent.
b. its average accounting return (AAR).
* c. its required return.
d. 100 percent
e. -100 percent
Answer: At the financial B/E, the NPV=0, and the IRR equals the required rate of return.
26
84. The time between when inventory is ______________________ is called the cash cycle.
a. acquired and when it is actually paid for
b. acquired and when it is actually sold
c. acquired and when cash is received for the sale
d. paid for and when it is sold
* e. paid for and when the cash is collected from the sale
Answer: This is the definition of the cash cycle.
Given the following information, answer the next five questions.
Item
Beginning
Ending
Inventory
Accounts Receivable
Accounts Payable
$15,000
$23,000
$11,000
$17,000
$22,000
$13,000
Net Credit Sales
Cost of Goods Sold
$150,000
$ 96,000
85. How many days are in the inventory period?
* a.
c.
e.
61 days
53 days
124 days
b.
d.
72 days
104 days
Answer: First calculate the Inventory Turnover. Inv. T/O = CGS/(Average Inventory) =
96000/15000 = 6 times
Then calculate the Inventory Period = 365/(Inventory T/O) = 365/6 = 61 days
86. How many days are in the receivables period?
a.
* c.
e.
41 days
55 days
88 days
b.
d.
47 days
72 days
Answer: A/R Turnover = (Credit Sales)/(Average A/R) = 150000/22500 = 6.666667
Receivables Period = 365/(A/R T/O) = 365/6.6666667 = 55 days
87. How many days are in the operating cycle?
a.
* c.
e.
74 days
116 days
165 days
b.
d.
80 days
141 days
Answer: Operating Cycle = Inventory Period + A/R Period = 61+55 = 116 days
88. How many days are in the payables period?
27
a.
* c.
e.
18 days
46 days
68 days
b.
d.
24 days
53 days
Answer: A/P Turnover = CGS/(Average A/P) = 96000/12000 = 8 times
Payables Period = 365/(A/P T/O) = 365/8 = 46 days
89. How many days are in the cash cycle?
* a.
c.
e.
70 days
95 days
123 days
b.
d.
88 days
117 days
Answer: Cash Cycle = Operating Cycle – A/P Period = 116 – 46 = 70 days
90.
Given the following information, what is the weighted average cost of capital (WACC)?
market value of equity
market value of debt
cost of equity
before tax cost of debt
equity beta
corporate tax rate
a.
c.
e.
7.2 percent
10.2 percent
13.5 percent
=
=
=
=
=
=
$30 million
$40 million
20 percent
9 percent
1.25
40 percent
*
b.
d.
9.0 percent
11.7 percent
Answer: WACC = (40/70)(9%)(1-.40) + (30/70)(20%) = 3.1% + 8.6% = 11.7%
91.
Which of the following statements is correct?
* a.
Decisions regarding a firm's debt and equity can be called financial structure decisions.
28
b.
c.
d.
e.
The asset beta is a measure of the unsystematic risk of a firm's assets.
In a capital restructuring, the composition of the assets of the firm will change.
The value of the overall firm will not change as a result of a capital restructuring if the NPV
of the restructuring is positive.
The use of personal leverage by an investor to alter the degree of financial leverage of a firm is
called reverse leverage.
Answer: Answer “a” is correct because financial structure decisions are those which affect the
right side of the balance sheet. Answer “b” is incorrect because beta measures systematic risk.
Answer “c” is incorrect because capital restructuring (same as financial restructuring) does not
change the left side of the balance sheet. Answer “d” is incorrect because the value will change if
the NPV is positive for any project (including restructuring). Answer “e” is incorrect because
personal leverage is called home-made leverage, not reverse leverage.
92. Assume there are no personal or corporate income taxes and that the overall cost of capital of a
firm is unaffected by its capital structure. Which of the following is true?
I. A firm will benefit from increased leverage.
II. The value of the firm is independent of its capital structure.
III. The cost of equity is a positive, linear function of the firm's capital structure.
a.
c.
* e.
I only
III only
II and III only
b.
d.
II only
I and III only
Answer: M&M proved that there would be no benefit from increased leverage and no change in
the firm value for any level of debt if there are no taxes (so I is incorrect and II is correct).
However, the cost of equity would increase as debt is added to the firm because of an increase in
risk (so III is correct).
93. Which of the following does not correctly complete the following: M&M I with taxes shows:
a.
* b.
c.
d.
e.
the value of a levered firm exceeds the value of the unlevered firm by the amount of the
present value of the interest tax shield.
a levered firm can increase its value by reducing debt.
the optimal amount of leverage for a firm is one hundred percent.
the value of an unlevered firm is equal to after-tax EBIT divided by the unlevered cost of
capital.
there is a linear relationship between the amount of debt in a levered firm and its value.
Answer: “b” is opposite the the conclusion of M7M with taxes. The firm value would decrease
when debt is reduced.
29
94. When choosing a capital structure (in the real world), the objective of the firm should be to:
a. choose the one that minimizes the current value of the stock.
* b. choose the one that maximizes the value of the firm.
c. choose the one that maximizes the firm's WACC.
d. choose the one that results in the greatest possible interest tax shield.
e. choose the one that minimizes the return on equity.
Answer: The object is to maximize the value of the firm or to minimize the WACC.
95. An unlevered firm has an EBIT of $1 million, net income after tax of $660,000, and a cost of
capital of 15 percent. A levered firm with the same assets and operations has $5 million in debt,
with an 8 percent yield to maturity. What is the value of the levered firm, using MM with
corporate taxes? (Tax rate is 34 percent.)
a. $1,000,000
b. $2,700,000
c. $3,966,667
*
d. $6,100,000
e. $6,776,923
Answer: First find the value of an unlevered firm, VU = 660,000/.15 = 4,400,000
Then find the levered value, VL = VU + t Debt = 4,400,000 + .34(5,000,000) = 6,100,000
96. A high income tax bracket investor who wants a low dividend because he has sufficient current
income would be most consistent with the:
a. bird-in-the-hand theory.
b. dividend irrelevance theory.
* c. tax differential theory.
d. asymmetric information theory
e. residual dividend theory.
Answer: This is the definition of the tax differential theory.
30